VC Funding for Tech Startups is Slowing: Here's Why

Two new reports released last week reveal that the bull market for venture capital funding in Silicon Valley is slowing down.

According to a new report from analysts at Mizuho Securities USA Inc., the funding of private tech companies in 2015 reached its highest level since 2009. However, even as the first three quarters saw venture capitalists increase their spending on new ventures, the last quarter saw pullbacks from the same people. The report's authors further add that the last tech bubble saw multiple years of elevated growth in VC investments, followed by a sharp acceleration in 1999 and a deceleration in 2000, followed by a bust in 2001. (See also: The 5 Most Important Venture Capital Deals of 2015.)

The current situation seems similar.

Chatter about the number of unicorns or billion-dollar-plus businesses in Silicon Valley was at a crescendo last year. However, as the global economy slowed down towards the end of the year, venture capitalists began pulling back. According to the report, venture money rose only by 16% in Q4 2015, compared to 68% during the last quarter of 2014.

Another report, this time from CB Insights and KPMG, states that VC deal value dropped from $38.6 billion in the third quarter of 2015 to $27.2 billion in Q4. Other quantitative metrics relating to venture capital funding also decreased. For example, total deal volume declined to 1,742 from 2,008. Mega-funding rounds also showed a precipitous decline from 72 during the third quarter to 38 in Q4.

What Caused the Funding Glut?

Persistently low ​interest rates were the main cause of the funding surplus. Low interest rates were originally intended to kick-start the economy. However, in the absence of viable government securities for investment, institutional investors, including foreign governments, began investing in startups as a way to get quick returns on their investment.

For example, Saudi Arabia's Kingdom Holding Company, which is owned by Prince Al Waleed bin Talal of Saudi Arabia, led a group of investors in buying a 5.3% stake in ride-sharing startup Lyft Inc. for $247.7 million last December. The hype around the technology industry, which is expected to make inroads into other industries in the near future, also helped attract investment and further reinforce the promise of rewards for startup investors.

The Fed's recent interest rate increase barely raised the barometer for low interest rates. What's more, the agency has promised a “gradual lift-off.” This translates into an era of prolonged low interest rates. (See also: The Impact Of The Fed Interest Rate Hike?)

The Beginning of the End?

It is tempting to compare 2015 to 1999, when the dot-com boom reached its peak and was about to go bust.

But there are some vital differences.

Back in 1999, there was persistently strong growth in the U.S. economy but little inflation. To get a better handle on the situation, the Fed raised interest rates to 5.25 percent at that time. As a result, Silicon Valley startups mostly attracted investors with little experience investing in technology startups who were looking to make a quick buck. The effects of the dot-com bust, although they were severe, were limited.

This time around, investors are being more careful.

For example, Square, Inc., which was bleeding cash, was forced to shell out $93 million to some investors during its IPO last year. The payment was part of a ratchet provision incorporated in its earlier funding rounds that guaranteed its investors specific returns, if the startup's share price went lower than their purchase price. (See also: 3 Reasons Square Low-Balled Its IPO Price). In addition, big ticket investments have mostly been limited to startups, such as Uber Technologies Inc., which already have healthy growth prospects.

The effect of a bust, if it occurs, is likely to be more severe in foreign markets. This is because the market for technology products is not as mature as in the United States. For example, consider the case of Indian unicorns, such as Flipkart and Snapdeal, which are yet to produce profits but have worked their way through several funding rounds and executive changes.

The Bottom Line

With the increase in interest rates by the Federal Reserve and renewed investor caution on investing in startups, the chances of a repeat of the 1999-style dot-com bust occurring are low. However, foreign startups, which do not benefit from the maturity and resilience of U.S. funding mechanisms, may find the going tough if they fail to produce returns within a given timeframe. (See also: Declining Venture Capital Offset by Digital Economy.)

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